August 9, 2018

5 Steps for Choosing Stocks

I often hear active investors lament the time and energy they spend identifying trade candidates. But with so many stocks to choose from—the New York Stock Exchange alone has more than 2,700—what's a trader to do? Consider these five steps.

1. Assess the market
Before you add a position, note how the broader market is moving, since research suggests that roughly 75% of stocks move in step with the market.1 Just like a rising tide lifts all boats, buying stocks when the market is trending higher may increase your odds of a successful trade.

Next, look at a major index's moving average (which shows the general trend in prices over a given period) to determine the market's momentum. If your trading time frame is two months, for example, you might look at the 50-day moving average of the S&P 500® Index in order to gauge the market's general direction over that period.

Pay attention, too, to potentially market-moving events that could affect your trade, such as Federal Reserve policy meetings or earnings announcements.

2. Identify a sector
Once you have a general picture of the market, home in on sectors and industries that look particularly promising. One approach is to track the performance of each of the 11 sectors defined by the Global Industry Classification Standard, or GICS® (see "Trouble In the Tech Sector?"), to see which have excelled in recent months. If the trend indicates possible difficulty ahead, you might want to focus on sectors or industries with more-defensive characteristics, such as Health Care and Utilities.

It also can be helpful to consult Schwab's biweekly Sector Views, which provides a short-term outlook for each GICS sector.

3. Screen for stocks
After you've found a sector you like, it's time to look for individual stocks. Schwab clients can use the screener tool, which allows you to filter by analyst rating, price performance, sector and more (see "Now screening," below).

To further narrow the list, try focusing on growth or value candidates. Growth stocks tend to have higher valuations that reflect the company's potential, while value stocks tend to have lower prices relative to current fundamentals. If you're interested in growth, you might screen for factors such as historical or projected growth rates. If you care more about value, you might screen for low price-to-book or price-to-earnings ratios. 

4. Review the fundamentals
With a short list of candidates in hand, it's time to dig into the details. First, check the investment commentaries available for each company. Are there any red flags such as a product recall or litigation against the company that could negatively impact the price? Conversely, are there factors such as a product launch or the announcement of a pending takeover that suggest the stock's price could rise in the future?

You might also look into each company's earnings, financial statements and ratings (such as the Schwab Equity Ratings® assigned to individual stocks). Don't go overboard, though: The goal is not to learn everything you can about each company but rather to identify details that might set one stock apart from another.

5. Check the charts
Once you've whittled your list to the most-promising candidates, look at each stock's trend line. In general, it's a good time to get into a trade if you can either buy into an uptrend or, alternatively, buy into a dip if you have reason to believe the decline is an anomaly.

As you fall into a rhythm with your stock-selection process, these steps should become second nature. But whatever methodology you apply, keep careful track of your expectations and reasons behind every trade—the better to learn from both your failures and your successes.

Now screening

Narrow your search with two Schwab tools.

  • Schwab clients can log in  to screen for trade candidates using a variety of criteria, including price, sector and technical metrics. The screen below, for example, searches for smaller-market-cap stocks that have above-average revenue and earnings growth and whose price action is outperforming its industry group.

  • Alternatively, clients can log in to compare performance among sectors and the S&P 500.

For illustrative purposes only.